GARCH

GARCH Models
Introduction ARMA models assume a constant volatility In nance, correct specication of volatility is essential ARMA models are used to model the conditional expectation They write Yt as a linear function of the past plus a white noise term

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|change| + 1/2 %

10

10

1970

1975

1980 year

1985

1990

1995

Absolute changes in weekly AAA rate

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30

20

10 percent net return

10

20

30

40 1994

1996

1998

2000 year

2002

2004

2006

Cree Daily Returns

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30

25 percent net return

20

15

10

1994

1996

1998

2000 year

2002

2004

2006

Cree Daily Returns

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GARCH models of nonconstant volatility ARCH = AutoRegressive Conditional Heteroscedasticity heteroscedasticity = non-constant variance homoscedasticity = constant variance

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ARMA unconditionally homoscedastic conditionally homoscedastic GARCH unconditionally homoscedastic, but conditionally heteroscedastic Unconditional or marginal distribution of Rt means the distribution when none of the other returns are known.

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Modeling conditional means and variances Idea: If is N (0, 1), and Y = a + b , then E (Y ) = a and Var(Y ) = b2 . general form for the regression of Yt on X1.t , . . . , Xp,t is Yt = f (X1,t , . . . , Xp,t ) + t (1) Frequently, f is linear so that f (X1,t , . . . , Xp,t ) = 0 + 1 X1,t + + p Xp,t . Principle: To model the conditional mean of Yt given X1.t , . . . , Xp,t , write Yt as the conditional mean plus white noise.

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Let 2 (X1,t , . . . , Xp,t ) be the conditional variance of Yt given X1,t , . . . , Xp,t . Then the model Yt = f (X1,t , . . . , Xp,t ) + (X1,t , . . . , Xp,t )
t

(2)

gives the correct conditional mean and variance. Principle: To allow a nonconstant conditional variance in the model, multiply the white noise term by the conditional standard deviation. This product is added to the conditional mean as in the previous principle. (X1,t , . . . , Xp,t ) must be non-negative since it is a standard deviation

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ARCH(1) processes Let 1 , 2 , . . . be Gaussian white noise with unit variance, that is, let this process be independent N(0,1). Then E ( t| and Var( t |
t1 , . . .) t 1 , . . . )

= 0, = 1. (3)

Property (3) is called conditional homoscedasticity.

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at =

0 + 1 a2 t1 .

(4)

It is required that 0 0 and 1 0 It is also required that 1 < 1 in order for at to be stationary with a nite variance. If 1 = 1 then at is stationary, but its variance is Dene
2 t = Var(at |at1 , . . .)

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From previous slide: at = Therefore a2 t = Since

t 2 t {0 t

0 + 1 a2 t1 . + 1 a2 t1 }.

is independent of at1 and Var( t ) = 1 E (at |at1 , . . .) = 0, (5) (6)

and
2 = 0 + 1 a2 t t 1 .

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From previous slide:

2 t = 0 + 1 a2 t1 .

If at1 has an unusually large deviation then the conditional variance of at is larger than usual at is also expected to have an unusually large deviation volatility will propagate since at having a large 2 deviation makes t +1 large so that at+1 will tend to be large.

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The conditional variance tends to revert to the unconditional variance provided that 1 < 1 so that the process is stationary with a nite variance. The unconditional, i.e., marginal, variance of at denoted by a (0)

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The basic ARCH(1) equation is

2 t = 0 + 1 a2 t 1 .

(7)

This gives us a (0) = 0 + 1 a (0). This equation has a positive solution if 1 < 1: a (0) = 0 /(1 1 ).

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If 1 = 1 then a (0) is innite. It turns out that at is stationary nonetheless.

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For an ARCH(1) process with 1 < 1:

k Var(at+k |at , at1 , . . .) = (0)+1 {a2 t (0)} (0) as k .

In contrast, for any ARMA process: Var(at+k |at , at1 , . . .) = (0).

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1.4
ARCH(1) case 1

1.3 1.2 Conditional variance 1.1 1 0.9 0.8 0.7 0.6 0

ARCH(1) case 2 AR(1)

10 k

15

20

Var(at+k |at , . . .) for AR(1) and ARCH(1). (0) = 1 in both cases. For ARCH(1), 1 = .9. Case 1: 2 a2 = 1 . 5 . Case 2: a t t = .5.

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independence implies zero correlation but not vice versa GARCH processes are good examples dependence of the conditional variance on the past is the reason the process is not independent independence of the conditional mean on the past is the reason that the process is uncorrelated

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Example: 0 = 1, 1 = .95, = .1, and = .8

White noise 3 2 1 4 0 3 1 2 3 0 20 40 60 2 1 6 5 Conditional std dev

20

40

60

ARCH(1) 4 2 0 5 2 4 6 10 5

AR(1)/ARCH(1))

20

40

60

15

20

40

60

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White noise 4 2 0 2 4 0 60 40 20 0 20 40 0 500 500 AR(1)/ARCH(1)) 20 60

Conditional std dev 100

ARCH(1)

40

50

0 0

500

50 0

500

normal plot of ARCH(1)

0.999 0.997 0.99 0.98 0.95 0.90 0.75 0.50 0.25 0.10 0.05 0.02 0.01 0.003 0.001 40 20

Probability

0 20 Data

40

Parameters: 0 = 1, 1 = .95, = .1, and = .8.

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Comparison of AR(1) and ARCH(1) AR(1) Yt = (Yt1 ) + t . ARCH(1) at = t t . t = 0 + 1 a2 t 1 .

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Comparison of AR(1) and ARCH(1) AR(1) E (Yt ) = . Et (Yt ) = + (Yt1 ). ARCH(1) E (at ) = 0. Et (at ) = 0.

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Comparison of AR(1) and ARCH(1) AR(1)

2 t = 2.

ARCH(1) 0 = . 1 1
2 2 t = 0 + 1 a2 t1 . 2 Recall: t = Var(at |at1 , . . .).

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The AR(1)/ARCH(1) model Let at be an ARCH(1) process Suppose that ut = (ut1 ) + at . ut looks like an AR(1) process, except that the noise term is not independent white noise but rather an ARCH(1) process.

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at is not independent white noise but is uncorrelated Therefore, ut has the same ACF as an AR(1) process: u (h) = |h| h. a2 t has the ARCH(1) ACF: a2 (h) = 1
|h|

h.

need to assume that both || < 1 and 1 < 1 in order for u to be stationary with a nite variance

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ARCH(q ) models let

t

be Gaussian white noise with unit variance

at is an ARCH(q ) process if at = t and

q t

t =

0 +
i=1

i a2 t i

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GARCH(p, q ) models the GARCH(p, q ) model is at = t t where

q p

t =

0 +
i=1

i a2 ti +
i=1

2 i t i .

very general time series model: at is GARCH(pG , qG ) and at is the noise term in an ARIMA(pA , d, qA ) model

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Heavy-tailed distributions stock returns have heavy-tailed or outlier-prone distributions reason for the outliers may be that the conditional variance is not constant GARCH processes exhibit heavy-tails Example 90% N (0, 1) and 10% N (0, 25) variance of this distribution is (.9)(1) + (.1)(25) = 3.4 standard deviation is 1.844 distribution is MUCH dierent that a N (0, 3.4) distribution

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Densities 0.4 0.3 0.2 0.01 0.1 0 5 0 5 10 0.005 0 4

normal normal mix

Densities detail 0.025 0.02 0.015

normal normal mix

10

12

Normal plot normal 0.997 0.99 0.98 0.95 0.90 0.75 0.50 0.25 0.10 0.05 0.02 0.01 0.003 2 1 0
Data

Normal plot normal mix 0.997 0.99 0.98 0.95 0.90 0.75 0.50 0.25 0.10 0.05 0.02 0.01 0.003 10 0
Data

Probability

Probability

10

Comparison on normal and heavy-tailed distributions.

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For a N (0, 2 ) random variable X , P {|X | > x} = 2(1 (x/ )). Therefore, for the normal distribution with variance 3.4, P {|X | > 6} = 2(1 (6/ 3.4)) = .0011.

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For the normal mixture population which has variance 1 with probability .9 and variance 25 with probability .1 we have that P {|X | > 6} = 2{.9(1 (6)) + .1(1 (6/5))} = (.9)(0) + (.1)(.23) = .023. Since .023/.001 21, the normal mixture distribution is 21 times more likely to be in this outlier range than the normal distribution.

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Property Cond. mean Cond. var Cond. distn Marg. mean & var. Marg. distn

Gaussian WN constant constant normal constant normal

ARMA non-const constant normal constant normal

GARCH 0 non-const normal constant heavy-tailed

ARMA/ GARCH non-const non-const normal constant heavy-tailed

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All of the processes are stationary marginal means and variances are constant Gaussian white noise is the baseline process. conditional distribution = marginal distribution conditional means and variances are constant conditional and marginal distributions are normal Gaussian white noise is the source of randomess for the other processes therefore, they all have normal conditional distributions

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Fitting GARCH models Fit to 300 observation from a simulated AR(1)/ARCH(1) Listing of the SAS program for the simulated data
options linesize = 65 ; data arch ; infile c:\courses\or473\sas\garch02.dat ; input y ; run ; title Simulated ARCH(1)/AR(1) data ; proc autoreg ; model y =/nlag = 1 archtest garch=(q=1); run ;

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SAS output
Q and LM Tests for ARCH Disturbances Order 1 2 3 4 5 6 7 8 9 10 11 12 Q 119.7578 137.9967 140.5454 140.6837 140.6925 140.7476 141.0173 141.5401 142.1243 142.6266 142.7506 142.7508 Pr > Q <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 LM 118.6797 129.8491 131.4911 132.1098 132.3810 132.7534 132.7543 132.8874 132.8879 132.9226 133.0153 133.0155 Pr > LM <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001 <.0001

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Variable Intercept AR1 ARCH0 ARCH1

Standard DF Estimate 1 1 1 1 0.4810 -0.8226 1.1241 0.6985

Approx Error t Value 0.3910 0.0266 0.1729 0.1167 1.23 -30.92 6.50 5.98

Pr > |t| 0.2187 <.0001 <.0001 <.0001

= .8226 AR parameter: this is +.8226 in our notation close to the true value of 0.8 estimates of the ARCH parameters: 0 = 1.12 (true value = 1) 1 = .70 (true value = .95)

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standard errors of the ARCH parameters are rather large approximate 95% condence interval for 1 is .70 (2)(0.117) = (.446, .934)

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Example: S&P 500 returns

0.15 0.1 0.05 return residual 0 0.05 0.1 0.15 0.2 60

65

70

75

80 year

85

90

95

Residuals when the S&P 500 returns are regressed against the change in the 3-month T-bill rates and the rate of ination.

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This analysis uses RETURNSP = the return on the S&P 500 DR3 = change in the 3-month T-bill rate GPW = the rate of wholesale price ination RETURNSP is regressed on DR3 and GPW (factor model)

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Model RETURNSP = 0 + 1 DR3 + 2 GPW + ut ut is an AR(1)/GARCH(1,1) process Therefore, ut = 1 ut1 + at , at is a GARCH(1,1) process: at = t t where t =
2 0 + 1 a2 + 1 t1 t1 .

(8)

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SAS Program Key command:

proc autoreg ; model returnsp = DR3 gpw/nlag = 1 archtest garch=(p=1,q=1);

returnsp = DR3 gpw species the regression model nlag = 1 species the AR(1) structure. garch=(p=1,q=1) species the GARCH(1,1) structure. archtest species that tests of conditional heteroscedasticity be performed

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SAS output The p-values of the Q and LM tests are all very small, less than .0001. Therefore, the errors in the regression model exhibit conditional heteroscedasticity. Ordinary least squares estimates of the regression parameters are:
Variable Intercept DR3 GPW DF 1 1 1 Estimate 0.0120 -0.8293 -0.8550 Standard Error 0.001755 0.3061 0.2349 t Value 6.86 -2.71 -3.64 Approx Pr > |t| <.0001 0.0070 0.0003

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Using residuals from the OLS estimates, the estimated residual autocorrelations are:
Estimates of Autocorrelations Lag 0 1 Covariance 0.00108 0.000253 Correlation 1.000000 0.234934

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Also, using OLS residuals, the estimate AR parameter is:

Estimates of Autoregressive Parameters Standard Error 0.046929

Lag 1

Coefficient -0.234934

t Value -5.01

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Assuming AR(1)/GARCH(1,1) errors, the estimated parameters of the regression are:

Variable Intercept DR3 GPW DF 1 1 1 Estimate 0.0125 -1.0665 -0.7239 Standard Error 0.001875 0.3282 0.1992 t Value 6.66 -3.25 -3.63 Approx Pr > |t| <.0001 0.0012 0.0003

Notice that these dier slightly from OLS estimates. Since all p-values are small, both independent variables are signicant. However, the Total R-square value is only 0.0551, so the regression has little predictive value.

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The estimated GARCH parameters are:

AR1 ARCH0 ARCH1 GARCH1 1 1 1 1 -0.2016 0.000147 0.1337 0.7254 0.0603 0.0000688 0.0404 0.0918 -3.34 2.14 3.31 7.91 0.0008 0.0320 0.0009 <.0001

Since all p-values are small, all GARCH parameters are signicant. GARCH1 (0.7254) >> ARCH1 (0.1337) reasonably long persistence of volatility.

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I-GARCH models I-GARCH or integrated GARCH processes designed to model persistent changes in volatility A GARCH(p, q ) process is stationary with a nite variance if
q p

i +
i=1 i=1

i < 1.

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A GARCH(p, q ) process is called an I-GARCH process if

q p

i +
i=1 i=1

i = 1 .

I-GARCH processes are either non-stationary or have an innite variance. Here are some simulations of ARCH(1) processes:

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= .9
1

50 0 50 100 150 0 200

0.5

1.5

2 1 = 1

2.5

3.5 x 10

4
4

100

100 0 5 x 10
4

0.5

1.5

2 1 = 1.8

2.5

3.5 x 10

4
4

5 0

0.5

1.5

2.5

3.5 x 10

4
4

Simulated ARCH(1) processes with 1 = .9, 1, and 1.8.

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= .9
1

0.999 0.997 0.99 0.98 0.95 0.90 0.75 0.50 0.25 0.10 0.05 0.02 0.01 0.003 0.001 100 80 60 40 20 0 20 40

Probability

1 = 1 0.999 0.997 0.99 0.98 0.95 0.90 0.75 0.50 0.25 0.10 0.05 0.02 0.01 0.003 0.001 50 0 50 1 = 1.8 0.999 0.997 0.99 0.98 0.95 0.90 0.75 0.50 0.25 0.10 0.05 0.02 0.01 0.003 0.001 4 3 2 1 0 1 2 3 4 x 10
4

Probability

100

150

Normal plots of ARCH(1) processes with 1 = .9, 1, and 1.8.

Probability

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Comments on the gures all three processes do revert to their mean, 0 larger the value of 1 the more the volatility comes in sharp bursts processes with 1 = .9 and 1 = 1 looks similar none of the processes in the gure show much persistence of higher volatility to model persistence of higher volatility, one needs an I-GARCH(p, q ) process with q 1 Next gure shows simulations from I-GARCH(1,1) processes

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= 0.95, Cond. std dev

1

= 0.4, Cond. std dev

1

= 0.2, Cond. std dev

1

= 0.05, Cond. std dev

1

30 25 20 15 10 5 0 0 1000 2000

30 25

200

40 35

150 20 15 10 50 5 0 0 1000 2000 0 0 1000 2000 100

30 25 20 15 10 5 0 1000 2000

1 = 0.95, GARCH(1,1) 30 20 10

1 = 0.4, GARCH(1,1) 40

1 = 0.2, GARCH(1,1) 300 200

1 = 0.05, GARCH(1,1) 100

20 100 0 0 100

50

0 10 20 20 200 0 1000 40 2000 0 1000 300 2000 0 1000 100 2000 0 1000 2000 50

Simulations of I-GARCH(1,1) processes. 1 + 1 = 1

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To t I-GARCH in SAS:
proc autoreg ; model returnsp =/nlag = 1 garch=(p=1,q=1,type=integrated); run ;

The default value of type is nonneg which only constrains the GARCH coecients to be non-negative. type=integrated in addition imposes the sum-to-one constraint of the I-GARCH model

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What does innite variance mean? let X be a random variable with density fX the expectation of X is

xfX (x)dx

provided that this integral is dened.

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If

xfX (x)dx =

(9)

and
0

xfX (x)dx =

(10)

then the expectation is, formally, + not dened if both integrals are nite, then the expectation is the sum of these two integrals

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Exercise: fX (x) = 1/4 if |x| < 1 and fX (x) = 1/(4x2 ) if |x| 1 fX is a density since

fX (x)dx = 1

Then expectation does not exist since

0

xfX (x)dx =

and
0

xfX (x)dx =

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What are the implications of having no expectation? assume sample of iid sample from fX law of large numbers sample mean will converge to the expectation law of large numbers doesnt apply if expectation is not dened there is no point to which the sample mean can converge it will just wander without converging

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1 = .9 0.5

0.5

1 0 4 2 0 2 4 6 0 15 10 5 0 5 0

0.5

1.5

2 1 = 1

2.5

3.5 x 10

4
4

0.5

1.5

2 1 = 1.8

2.5

3.5 x 10

4
4

0.5

1.5

2.5

3.5 x 10

4
4

Sample means of ARCH(1) processes with 1 = .9, 1, and 1.8.

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What are the implications of having innite variance now suppose that the expectation of X exists and equals X the variance

(x X )2 fX (x)dx

if this integral is + then the variance is innite law of large numbers sample variance will converge to the variance variance of X is innity the sample variance will converge to innity

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= .9
1

8 6 4 2 0 0 150

0.5

1.5

2 1 = 1

2.5

3.5 x 10

4
4

100

50

0 0 4 3 2 1 0 0 x 10
5

0.5

1.5

2 1 = 1.8

2.5

3.5 x 10

4
4

0.5

1.5

2.5

3.5 x 10

4
4

Sample variances: ARCH(1) with 1 = .9, 1, and 1.8.

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GARCH-M processes if we t a regression model with GARCH errors could use the conditional standard deviation (t ) as one of the regression variables when the dependent variable is a return the market demands a higher risk premium for higher risk so higher conditional variability could cause higher returns

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GARCH-M models in SAS add keyword mean, e.g.,

proc autoreg ; model returnsp =/nlag = 1 garch=(p=1,q=1,mean); run ;

or for I-GARCH-M
proc autoreg ; model returnsp =/nlag = 1 garch=(p=1,q=1,mean,type=integrated); run ;

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GARCH-M example: S&P 500 GARCH(1,1)-M was t in SAS is the regression coecient for t = .5150 standard error = .3695 t-value = 1.39 p-value = .1633

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since p-value = .1633 could accept the null hypothesis that = 0 no strong evidence that there are higher returns during times of higher volatility. volatility of S&P 500 is market risk so this is somewhat surprising (think of CAPM) is may be that the eect is small but not 0 ( positive, after all) AIC criterion does select the GARCH-M model

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E-GARCH E-GARCH models are used to model the leverage eect prices become more volatile as prices decrease E-GARCH, model is
q p

log(t ) = 0 +
i=1

1 g (

ti )

+
i=1

i log(ti ),

where g ( t ) = t + {| t | E (| t |)} log(t ) can be negative no constraints on parameters

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From the previous page: g ( t ) = t + {| t | E (| t |)} To understand g note that g ( t ) = E (| t |) + ( + )| t | if and g ( t ) = E (| t |) + ( )| t | if

t t

> 0,

< 0,

< 0 so that 0 < + < typically, 1 < = .7 in the S&P 500 example E (| t |) = 2/ = .7979 (good calculus exercise)

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= 0.7
6 5 4 6 5 4

=0

g( t )

3 2 1 0

g( t )
2 0 2 4

3 2 1 0

1 4

t = 0.7

1 4

t = 1

6 5 4

6 5 4

g( t )

3 2 1 0

g( t )
2 0
t

3 2 1 0

1 4

1 4

0
t

The g function for the S&P 500 data (top left panel) and several other values of .

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SAS ts the E-GARCH model xed as 1 estimated E-GARCH model is specied by using type=exp as in:
proc autoreg ; model returnsp =/nlag = 1 garch=(p=1,q=1,mean,type=exp); run ;

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Back to the S&P 500 example SAS can t six dierent AR(1)/GARCH(1,1) models type = integrated, exp, or nonneg GARCH-in-mean eect can be included or not following table contains the AIC statistics models ordered by AIC (best tting to worse)

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Model E-GARCH-M E-GARCH GARCH-M GARCH I-GARCH-M I-GARCH

AIC 1783.9 1783.1 1764.6 1764.1 1758.0 1756.4

AIC 0 0.8 19.3 19.8 25.9 27.5

AIC statistics for six AR(1)/GARCH(1,1) models t to the S&P 500 returns data. AIC is change in AIC between a given model and E-GARCH-M.

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AR(2) and E-GARCH(1,2)-M, E-GARCH(2,1)-M, and E-GARCH(2,2)-M models were tried none of these lowered AIC none had all parameters signicant at p = .1

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Listing of SAS output for the E-GARCH-M model:

The AUTOREG Procedure Estimates of Autoregressive Parameters Standard Lag Coefficient Error t Value 1 -0.234934 0.046929 -5.01 Algorithm converged. Exponential GARCH Estimates SSE 0.44211939 Observations 433 MSE 0.00102 Uncond Var . Log Likelihood 900.962569 Total R-Square 0.1050 SBC -1747.2885 AIC -1783.9251 Normality Test 24.9607 Pr > ChiSq <.0001

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Variable Intercept DR3 GPW AR1 EARCH0 EARCH1 EGARCH1 THETA DELTA

DF 1 1 1 1 1 1 1 1 1

Estimate -0.003791 -1.2062 -0.6456 -0.2376 -1.2400 0.2520 0.8220 -0.6940 0.5067

Standard Error 0.0102 0.3044 0.2153 0.0592 0.4251 0.0691 0.0606 0.2646 0.3511

t Value -0.37 -3.96 -3.00 -4.01 -2.92 3.65 13.55 -2.62 1.44

Approx Pr > |t| 0.7095 <.0001 0.0027 <.0001 0.0035 0.0003 <.0001 0.0087 0.1490

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The GARCH zoo Heres a sample of other GARCH models mentioned in Bollerslev, Engle, and Nelson (1994): QARCH = quadratic ARCH TARCH = threshold ARCH STARCH = structural ARCH SWARCH = switching ARCH QTARCH = quantitative threshold ARCH vector ARCH diagonal ARCH factor ARCH

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GARCH Models in Finance Remember the problem of implied volatility it depended on K and T ! Black-Scholes assumes a constant variance But GARCH eects are common so the Black-Scholes model is not adequate Having a volatility function (smile) is a quick x but not logical

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0.04 implied volatility 0.035 0.03 0.025 0.02 0.015 150 100 50 maturity 0 35 45 40 exercise price 55 50

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Options can be priced assuming the log-returns are a GARCH process (rather than a random walk) Multinomial (not binomial) tree to have dierent levels of volatility Need to keep track of price and conditional variance

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Ritchken and Trevor use an NGARCH (nonlinear asymmetric GARCH) model: log(St+1 /St ) = r + ht ht /2 + ht t+1

ht+1 = 0 + 1 ht + 2 ht (t+1 c)2 where t is WhiteNoise(0, 1). c = 0 is an ordinary GARCH model is a risk premium Under the risk-neutral (martingale) measure: log(St+1 /St ) = (r ht /2) + ht+1 = 0 + 1 ht + 2 ht ( where c = c + and
t

ht

t+1 ,

2 c ), t+1

is WhiteNoise(0, 1).

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Now there are ve unknown parameters: h0 1 , 2 , and 3 c These parameters are estimated by nonlinear least-squares Implied GARCH parameters

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Volatility smile is explained as due to GARCH eects: nonconstant variance nonnormal marginal distribution

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From Chapter 7, Bank of Volatility, of When Genius Failed by Roger Lowenstein: Early in 1998, Long-Term began to short large amounts of equity volatility. This simple trade, second nature to Rosenfeld and David Modest, would be indecipherable to 999 out of 1,000 Americans. Equity vol comes straight from the Black-Scholes model.

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The stock market, for instance, typically varies by about 15 percent to 20 percent a year. And when the model told them that the markets were mispricing equity vol, they were willing to bet the rm on it. The options market was anticipating volatility in the stock market of roughly 20 percent. Long-term viewed this as incorrect ... Thus, it gured that options prices would sooner or later fall.

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Long-Term began to short options on the S&P 500 are similar European options. They were selling volatility. In fact, it sold insurance (options) both waysagainst a sharp downturn and against a sharp rise.

GARCH

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0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0 1994

S&P 500 absolute log return

1996

1998

2000

2002

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AR(1)/EGARCH(1,1) model 0.5 0.45 S&P500, conditional SD, annualized 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 1997

1998

1999

2000

2001

Annualized SD =

253 daily variance

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data capm ; set Sasuser.capm ; logR_sp500 = dif(log(close_sp500)) ; logR_msft = dif(log(close_msft)) ; run ; proc gplot ; plot logR_sp500*date ; run ; proc autoreg ; model logR_sp500 = /nlag=1 garch=(p=1,q=1,type=exp) ; output out=outdata cev=cev ; run ; proc gplot ; plot cev*date ; run ;

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nlag 1 1 1 1 1 1 0 2 1 2 2 1

p 2 1 1 1 2 1 1 2 2 2 3 3

q 2 2 2 2 1 1 1 2 2 3 2 2

E-GARCH no no yes yes yes yes yes yes yes yes yes yes

M-GARCH no no no yes no no no no no no no no

AIC 14,366 15,002 15,105 15,103 15,105 15,107 14,366 15,112 15,104 15,100 15,100 15,101

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In fact, it sold insurance (options) both waysagainst a sharp downturn and against a sharp rise.
110 stock price 100

90 0 call price 10 5 0 0 put price

0.2

0.4

0.6

0.8

0.2

0.4

0.6

0.8

4 2 0 0 0.2 0.4 time 0.6 0.8 1

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The Greeks C (S, T, t, K, , r) = price of an option = C (S, T, t, K, , r) S = C (S, T, t, K, , r) t C (S, T, t, K, , r) R= r V= C (S, T, t, K, , r) Delta Theta Rho Vega

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90

Put-call parity Put and call prices with same K and T are related: P (S, T, t, K, , r) = C (S, T, t, K, , r) + er(T t) K S. Therefore, the call and put have the same vegas P (S, T, t, K, , r) = C (S, T, t, K, , r) but dierence deltas P (S, T, t, K, , r) = C (S, T, t, K, , r) 1 S S 0 < (call) = (d1 ) < 1 1 < (put) = (d1 ) 1 < 0

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From previous slide: 1 < (put) = (d1 ) 1 < 0 Suppose we buy N1 call options and N2 put options. Delta of the portfolio is N1 (d1 ) + N2 ((d1 ) 1) which is zero if N1 1 (d1 ) = N2 (d1 )

Hedging is possible with a put and call with dierent K and T each then has its own value of d1

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Selling equity vol was very clever, but as Lowenstein remarks: This wasso unlike the partners credorank speculation.